Here come the technocrats, to save the Eurozone

Author

Disclosure statement

Remy Davison does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.

Is the Eurozone about to crash and burn, leaving Club Med in its wake? Not so fast.

Reports have suggested that French President Nicolas Sarkozy and German Chancellor Angela Merkel have discussed a strategic retreat that would shrink the Eurozone to just six or seven “core” members, with an outer periphery, comprising the PIIGS (Portugal, Ireland, Italy, Greece and Spain).

There’s only one problem: none of the PIIGS is considering exiting the Eurozone. In fact, not one of them has even canvassed the idea of re-introducing their former national currency. And that wouldn’t solve the EU debt problem: the PIIGS’ bonds are denominated in euro and creditors aren’t interested in being repaid in debased currencies backed by nothing more than promises.

A whirlwind tour of Europe’s capitals will give us some insight into where we’re heading.
French Prime Minister Nicolas Sarkozy at the G20 summit in Cannes in November.AAP

Midnight in Paris

In France, the situation is serious, but not hopeless. In early November, Sarkozy lost his key ally, ECB President Jean-Claude Trichet, who was replaced by Italian central banker Mario Draghi. Last week, global markets were momentarily rocked by Standard & Poors’ (S&P) accidental downgrading of French debt from a AAA rating. The news of the downgrade went out to S&P’s clients before a hasty correction was issued. But all it did was add further fuel to the rumours that France’s sovereign bond market was in trouble. Deep trouble. Indeed, the gap between French and German bonds widened last week to 3.46%, meaning Paris pays more than double the interest on its debt that Berlin does.

French economist Jacques Attali, a former boss of the European Bank for Reconstruction and Development argued last week: “Let’s not have any illusions. On the markets, French debt has already lost its AAA.” Frère Jacques is right: bond buyers have already factored in the costs of long-term French debt. The reason why the spread between German and French debt yields is growing is because France is already AA in the minds of bond brokers.

Twilight in Rome

That’s still not as bad as Italy, where la dolce vita is no longer anywhere in evidence. Italy has passed a not-particularly-severe austerity law, but Rome still pays twice as much as Paris for its borrowings and its public debt market is the world’s biggest. If Greece sneezes, some French and German banks get a cold. If Italy sneezes, the global economy contracts viral pneumonia. Consigning Silvio Berlusconi and his bunga bunga parties to the dustheap hasn’t changed that.
Hand it over - Lucas Papademos takes over in Greece.AAP

Darkness in Athens

At the G20 summit earlier this month, Sarkozy said aloud what everyone has been thinking for a decade: Greece should never have been permitted to enter the Eurozone in the first place.

The problem is that ship sailed in 2001 and the Eurozone is one egg than cannot be unscrambled.

However, Eurogroup chairman Jean-Claude Juncker flagged the possibility of a Greek exit recently, although he tempered his comments, stating that Greece’s departure was “not his favoured scenario”.

Pundits, armchair commentators and economists who should know better have publicly canvassed the idea that it might be preferable if Greece simply defaults, exits the Eurozone and introduces a “New Drachma”.

Put simply, they are wrong. Economists who write of a 50% devaluation of a revamped Greek currency are wildly optimistic. The introduction of a so-called “New Drachma” would be worthless. It would be, as Erik Nielsen, global chief economist at UniCredit argues, “complete chaos”.

The death of the Eurozone?

EU Commission President Manuel Barroso spoke the unspeakable last week, warning that a collapse of the Eurozone could cost up to 50% of Europe’s GDP, causing a deep depression. A folding Eurozone would cost over 1 million jobs in Germany, wipe $US10 trillion – yes, $US10 trillion – off Europe’s ledgers and devastate the world economy, Barroso said.

If Asia, the Middle East or any other region in the global economy believes it is immune to such a crisis, it had best think again. Europe is China’s biggest export destination. Already, Chinese exports to the EU have more than halved this financial year. So, what is to be done?

Option A: Take a fast boat to China

Not really an option. Beijing has no desire (nor, really, the means) to become the world’s banker. It’s not about to sink its hard-won foreign reserves into Euro debt that may never be repaid. Futile Euro missions to President Hu Jintao have already proven they weren’t worth the first-class airfare.

Ben Bernanke quantitative easing approach won’t work.AAP

Option B: Quantitative easing

Also not really an option. This would mean adopting the American way of simply printing currency ad infinitum to inflate debt away, producing a world awash with worthless paper. The last time the Germans tried that trick was in 1923, and the French and Belgians occupied the Rhineland. No, this isn’t an option either.

Option C: The ECB as lender of last resort

Possibly an option. Speculator George Soros mused on this recently, although his seven-point plan was so radical, it meant effectively abolishing private markets for public debt. Under this scenario, the ECB could buy up sovereign debt bonds, as private investors are understandably reluctant. Irish debt, for instance, is junk, so no sane private-sector buyer will touch them. Portugal is in the same boat. On the downside, it would mean the ECB would have to dip into its reserves (and print money: see Option B) to unplug these failing arteries. But we all have our crosses to bear. The Eurozone could deploy the 440 billion euro European Financial Stability Facility (EFSF), but that isn’t big enough to rescue Italy. And the Germans are disinclined to raid it anyway.

Option D: The incredible shrinking Eurozone (or raise the Titanic)

This past week, the “Frankfurt Group”, comprising Germany, France, the ECB and some people they met at a party have reportedly considered jettisoning Greece and, possibly, a few other PIIGS, from the Eurozone. The trick will be to do it without anyone noticing. A Eurogroup made up of “core Europe”, comprising the Rhenish capitalists of Germany, France, the Netherlands, Belgium, Luxembourg and Austria, could dump Club Med out of the Eurozone for the sake of stability. The only problem with this scenario is that the PIIGS all get a say in whether they want to be or not want to be in the Eurozone. And while the Frankfurt Group all want to row off in the last remaining lifeboats, the PIIGS actually feel safer on the Titanic.
Could Germany be the only winner?AAP

Zero option

How would any of this help? A shrunken Eurogroup, it’s thought, could engage in a competitive devaluation of the euro. This would reduce the relative value of the PIIGS’ debts (see Option B). It could also increase Eurozone export growth. And it sure is a heck of a lot easier than innovating or competing your way out of recession.

Yes, it’s exactly what every country did in the 1930s: devalue your currency to gain a competitive advantage, blanket yourself with tariff protection and hope for the best. Did global trade collapse in the 1930s? Only by 70%.

Make no mistake: the prospect of a deep, prolonged global recession is very real, and Beijing is alert to the fact that the Chinese economy could be badly damaged in a world with a stagnant America and a stagflationary Europe.

Let’s finish with a fun fact: in 2002, when the euro currency was introduced, every single member country burned/crushed/otherwise destroyed its francs, pesetas and lira.